District Court Finds Fees Paid to Qui Tam Counsel in 2003 are Deductible
In Bagley v. United States, 2013 U.S. Dist. LEXIS 109801 (C.D. Cal. Aug. 5, 2013), the US District Court for the Central District of California held that a qui tam relator who diligently assisted the government throughout the litigation of two federal False Claims Act (FCA) cases against the defense contractor, TRW, Inc., investing almost 6,000 hours of his time over 9 years, could deduct his attorney’s fees from the taxes owed on his recoveries in the actions because they were “ordinary and necessary expenses” relating to a “trade or business” within the meaning of 26 U.S.C. § 162(a) .
The Court’s ruling addressed the deductibility of the fees in 2003, a tax year that predated the effective date of the amendment of the Internal Revenue Code that expressly permits litigants to exclude from their adjusted gross income attorneys’ fees incurred in connection with FCA cases. See 26 U.S.C. §§62(a)(20), effective October 22, 2004.
Factual and Procedural Background
In 1994 and 1995, the relator, who had been employed by TRW as a financial manager, among other positions, brought qui tam actions against his former employer. The United States intervened in one action prior to litigation and intervened in the second action after the relator had litigated the case on his own for some time. After 9 years of litigation, the relator’s cases against TRW settled for $111 million. The relator, who lost his job before he brought the case and never found another job, made critical contributions throughout the litigation, devoting almost 6,000 hours to the cases. He was awarded a relator’s share of 24.5% of the recovery (an award of more than $27 million). He also recovered more than $9 million in statutory attorneys’ fees. In total, the relator paid more than $18 million to his counsel. He initially reported the relator share award and attorneys’ fees recovery to the IRS as ordinary income. Later, though, he sought to amend his return to claim the award as profit or loss from a business and to deduct the legal fees that he paid to his attorneys as ordinary and necessary business expenses. The IRS denied the amended return, and the relator filed suit.
The Court’s Holding
The Court held that although two possible tests might apply to determine whether relator could deduct his legal fees—the ‘Trade or Business Test’ and the ‘Origin and Nature of the Claim Test’—under either test the relator could deduct his legal fees as a business expense under 26 U.S.C. § 162(a). 2013 U.S. Dist. LEXIS 109801 at *25–27. Applying the ‘Trade or Business Test,’ Judge Timlin determined that the relator could deduct his fees because he had pursued the claim continuously, regularly, and with the primary purpose of generating income for himself. Id. at *27–28. A host of factors favored this conclusion, including the documented hours the relator spent working on the case and the critical expertise and contributions he made to the highly favorable outcome. Id.at *32–40. Turning to the ‘Origin and Nature of the Claim Test,’ the Court explained that the relator did not himself have a personal stake in the damages sought in the action, which were suffered solely by the government. Id. at 49–50. Rather, the FCA authorized the relator to pursue the action as the government’s agent; thus, the award was given to him “in exchange for the information and services” he provided. Id. at *50–51. Because those services bore the “indicia of a business enterprise,” the relator’s associated legal fees were a business expense under the ‘Origin and Nature of the Claim Test’ as well. Id. at 51.